“To reduce risk, it is necessary to avoid a portfolio whose securities are all highly correlated with each other.” Harry Markowitz – American economist
Given the past 3 years of S&P 500 returns (31% in 2019, 18% in 2020, and 29% in 2021), many investors may be suffering from “recency bias.” The term recency bias refers to the tendency to place too much emphasis on recent events. For example, you may be inclined to chase last year’s winner by moving a larger percentage of your portfolio to the asset class that had the best performance in the prior year. This can lead investors to deviate from their financial goal plans, which can have damaging long-term consequences.
The Asset Class Returns chart (below) highlights the difficulty of selecting the best performing investment year after year. Assets at the top of the chart one year could be at the bottom the next, and vice versa.
Diversification: Depth vs. Breadth
Given our inability to know which asset class will be the performance hero each year, our investment philosophy is to diversify across a reasonably large number of asset classes. Reducing the volatility of returns in the overall portfolio is achieved by combining assets that tend to have low correlation to each other. Vertical diversification (depth) is diversification within a particular asset class. For example, the S&P 500 index is a collection of 500 stocks – all of which fall into one asset class: large-cap U.S. stock. Horizontal diversification (breadth) is achieved by investing in a wide variety of distinct asset classes – such as large-cap stock, small-cap stock, real estate, foreign stock, U.S. bonds, etc. Rather than attempting to pick the winning horse, our approach is to own the entire herd.
Over time, asset classes produce different returns that can change the portfolio’s initial asset allocation. To recapture the portfolio’s original risk-and-return characteristics, the portfolio is rebalanced. Systematic rebalancing enforces a “sell high and buy low” strategy that often improves a portfolio’s returns and protects it against long-term market fluctuations. Rebalancing may also help investors avoid trading on emotion. Investors may have to overcome recency bias and curb impulses during the rebalancing process as they sell off some of the best performers and put that money into the underperformers. Our investment philosophy is to rebalance at least annually, so our clients’ investment policy aligns with their long-term financial goal plan.